There are two principle gold markets for bullion gold and silver. For the purposes of this discussion, we’ll assume that the silver market functions in a similar enough manner to make an analogy from the gold market. We’ll delve into the differences between the silver and gold market in a later post.
The two primary markets that determine the price of gold are the spot market and the futures market. The spot market is the market where gold for immediate delivery trades. Despite the name, not every transaction that happens in the spot market has a physical exchange of goods, but anyone who has access to the spot market must be able to make delivery of gold on demand.
The gold futures market is the market for gold at some date in the future. Gold futures trade on the COMEX (Commodities Exchange) in New York, now part of the CME Group (Chicago Mercantile Exchange). The gold futures contract is used by institutions as well as speculators. A futures contract is a standardized agreement to deliver or receive a specific amount of gold at some point in the future. The COMEX gold futures contract specifies delivery of 100 troy ounces of 995 pure gold. The notional value of the contract, based on a current gold price of $1390/Troy ounce is $139,000.00. (One Imperial, traditional, ounce = 28.35 grams; One Troy ounce = 31.10 grams)
In early November, 2010 the CME launched a new gold futures contract, the e-micro. The e-micro is identical to the traditional gold futures contract except that it trades a notional 10 troy ounces of gold. If one makes or takes delivery of this contract, 10 ounces of gold changes hands. The e-micro can be thought of as a fractional traditional gold futures contract, so 10 e-micros equal one traditional contract.
The contract allows a trader take a position that benefits from a rise in the price of gold or from a fall in price. Futures contract are designed to be uniform and can be long or short. If one is long, then they effectively buy gold, they own the commodity and benefit when the price rises. If one sells a gold contract and “gets short,” then effectively, they sell gold. If the price drops, then they can buy their gold back for less than they paid. It is “buy-low, sell high,” but in reverse.
Futures markets are predictive. Participants seek to anticipate where the price of gold will be near the end of the contract and invest accordingly. The futures price of any commodity is based on price expectations and the interest rate. Interest rates matter because there is an opportunity cost to investing money in a futures contact. The money is not earning interest in a bank account, so that opportunity cost is factored into the futures price of gold by the market. Because interest rates are currently low, and a small part of the price factor, for our purposes we can ignore the interest rate impact.
Despite the futures contract requiring physical delivery of 100 Troy ounce of gold, most contracts are closed before expiration requires delivery and it is not the norm that gold is physically exchanged. Even among large gold users, traders and investors, most gold is exchanged by electronic transfer while the physical good remains safely locked behind several layers of security at large, well protected banks and vault institutions. If one does take delivery of a gold contract, one actually receives a warrant for gold from a clearing depository.